A well-diversified portfolio can help investors reap greater returns while minimizing risk. Incorporating real estate into your investment mix is one way to achieve better diversification, but it can be tricky to get the most out of it. Read on for our expert advice on how to make real estate work for you in an effective and profitable way.
Understand the Benefits of Investing in Real Estate
One of the main advantages of incorporating real estate into your investment portfolio is that it can help to maximize returns and minimize long-term risk. Real estate tends to increase in value over time, as opposed to stocks and other assets which may see more drastic swings in market values. Additionally, there are potential tax benefits associated with real estate investments, such as deductions for depreciation and repairs. Lastly, real estate investments tend to appreciate more steadily than other asset classes, providing a more predictable and consistent stream of income for investors.
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Consider Your Goals and Plans for the Property
Before you decide to invest in real estate, it’s important to consider what your goals and plans for the property are. Are you looking for passive income? Are you planning on flipping the property? Do you want to receive rental income over a longer term? Additionally, make sure that you identify any potential risks associated with the investment, such as market conditions, local economic factors, and government regulations. Knowing these factors will help you best allocate your resources and maximize your portfolio diversification.
How to Diversify Your Portfolio with Real Estate
Once you’ve identified your investment goals, you can start to consider ways to diversify your portfolio by investing in real estate. Diversifying your investment portfolio with real estate can provide various benefits, including risk mitigation, income generation, and potential for long-term appreciation. Here are some strategies to consider when diversifying your investment portfolio with real estate:
Consider how you plan to take ownership of the property. To achieve maximum diversity, you might want to own some property individually and outright, such as owning a small multifamily apartment building. Meanwhile, you might want to take a backseat role by investing in a larger scale property through a real estate fund or syndication. For example, you might want to own a fractional share of a real estate strip center that you would only have access to via a syndication. There are other ways to diversify your real estate ownership, as well. You could also consider investing in real estate investment trusts (REITs). Many REITs specialize in different property types. You could, for instance, invest $25,000 into an apartment REIT and another $25,000 into an office REIT depending on your preferences and current market conditions.Other investment vehicles include real estate crowdfunding platforms, real estate partnerships, and real estate investment clubs. Each investment vehicle may offer unique opportunities and risk profiles, allowing you to diversify your exposure within the real estate market.
Product Type Diversification:
Consider balancing your portfolio by investing in different real estate product types. This helps to mitigate against unexpected market downturns that impact certain property types more than others. For example, during the latest COVID market correction, multifamily apartment buildings continued to outperform while office buildings suffered. Owning an array of asset types provides some insulation against one sector plummeting.
There are more commercial real estate product niches than people may realize. These include: office, hospitality/hotels, retail, multifamily, seniors housing, industrial, life science, data centers, cold storage, student housing, medical office buildings, land, and more. Each property type has its own risk and return characteristics, and diversifying across types helps spread risk.
Market Segment Diversification:
In addition to investing in different product types, consider investing across various market segments within a property type. For example, in the residential sector, you might consider investing in single-family homes, apartment buildings, student housing, and/or senior living facilities. Diversifying within each property type allows you to benefit from different market dynamics and tenant profiles.
Property Class Diversification:
Properties are generally characterized as Class A, B, or C. Class A buildings are newer, have more amenities, tend to have the most credit-worthy tenants, and are considered the “safest” commercial real estate investments. We’ve seen this even during the most recent market downturn. Despite the office market struggling, there has been a “flight to quality” with Class A buildings outperforming Class B or C office buildings.
Class B and C properties tend to be older, less well located, and often need significant upgrades and investment to compete with their Class A counterparts. Class B and C properties can be excellent investments for those willing to engage in a value-add business strategy. Some may find that these properties, when purchased at a low basis, can also cash flow incredibly well.
Owning properties of varying classifications can provide further portfolio diversification. Someone who is an expert in any product type (e.g., office) can often earn tremendous returns across the classification spectrum by knowing how to optimize individual properties.
Property Size Diversification:
Invest in properties of varying sizes. Consider properties ranging from small residential units to large commercial or industrial buildings. Small properties may offer stability and ease of management, while larger properties may provide potential for higher returns. Diversifying property size helps distribute risk.
Invest in real estate properties located in different cities, regions, or even countries. Real estate markets can vary significantly based on local economic factors, population growth, and other market dynamics. By diversifying geographically, you reduce the risk of concentration in a single market and potentially benefit from different economic cycles and opportunities.
Investment Strategy Diversification:
Consider investing in real estate funds that focus on different real estate investment strategies, such as core, value-add, or opportunistic investments. These funds typically have a diversified portfolio of properties and allow you to gain exposure to different risk profiles and potential returns. By investing in multiple funds with varying investment strategies, you can diversify your portfolio holdings.
If you’re planning to passively invest in real estate, invest alongside different sponsors. For instance, you might invest $50,000 with one and $50,000 with another. This way, if a deal goes sideways or if a sponsor’s business becomes insolvent, you don’t have the risk of all of your hard-earned capital being tied up with that one company.
Diversification of Hold Period:
There are certain tax benefits associated with owning real estate, such as the ability to take bonus depreciation. There may be reasons to acquire and sell properties at certain intervals to maximize those benefits. Consider a property’s hold period, how long your capital will be illiquid, and whether this hold period aligns with your specific investment objectives.
Exit Strategy Diversification:
Some owners decide to fix and flip a property, selling shortly after stabilization. Others will refinance upon stabilization to reap the benefits of increased value, often paying out limited partners in the process. Either of these instances can result in large lump-sum payments that have tax implications for real estate investors. Instead, you might be better off with a long-term buy and hold strategy where you earn steady, incremental cash flow from the deal. Investing in properties with different exit strategies is another way to maximize portfolio diversification.
Capital Allocation Diversification:
Similar to sponsor diversification, consider allocating your capital across multiple real estate investments. This is important for those who feel very strongly investing with one specific sponsor; if you invest in multiple deals with that sponsor, you mitigate against the risk of having all of your money tied up in one deal. This helps reduce the impact of any single investment on your overall portfolio performance.
Most people use some combination of debt and equity to acquire commercial real estate. Consider spreading your risk out by taking out loans from different lenders or banks. Evaluate your portfolio’s overarching loan-to-value ratio and if that number seems too high for your risk tolerance, be sure to use less leverage in future deals to balance your portfolio. Use bridge loans as necessary, and consider taking out loans with interest-only periods in order to maximize returns as needed.
Service Provider Diversification:
Whether you own investment property directly or indirectly, consider partnering with various service providers (e.g., real estate brokers, property managers, asset managers, contractors, etc.). Those who have a single “go to” service provider may end up paying higher fees than those who competitively bid out the work on a regular basis. Moreover, it minimizes the risk of becoming too engrained with a single provider which can become problematic if that provider underperforms for one reason or another.
Consider Investing in Real Estate Debt
Most people assume that the only way to invest in commercial real estate is by investing equity in deals. Another option is to invest in real estate debt. Real estate debt investments, such as mortgage-backed securities or real estate debt funds, can provide diversification within the real estate asset class. These investments require lending money to real estate projects or investing in debt instruments secured by real estate. By including real estate debt in your portfolio, you can potentially benefit from fixed-income returns that have a lower correlation with equity markets.
Remember, achieving maximum real estate diversity requires careful planning, research, and the ongoing monitoring of your investments. It’s essential to assess your risk tolerance, financial goals, and seek professional guidance to create a diversified real estate portfolio that aligns with your objectives.
It may also mean selling individual properties that are otherwise dragging down your portfolio’s overall performance. Those losses can be used to offset the gains from other, more successful properties.
Of course, how you invest in real estate – including how much you invest in real estate, should be considered as part of an otherwise balanced portfolio. Commercial real estate is considered an alternative asset class. Most people will want no more than 25% of their investment portfolio concentrated in alternative investments, but this can certainly vary depending on a person’s risk tolerance and investment horizon. Consult with your investment advisor to discuss within the context of your own goals.